Chapter 7: Capital Markets - Bonds

American-Style

a bond that makes coupon payments every six months

• amount equals ½ the coupon rate * face value

ask price/offer price

the high price at which a dealer is willing to sell to a buyer - the price at which the client buys

bearer bonds

bonds where the person holding the paper bond receives the bond’s cash flows

bellwether/benchmark bond

the most recently issued 30-year U.S. treasury bond

bid price

the low price at which a dealer is willing to buy from a seller - the price at which the client sells

bid-ask spread

the per-unit profit a dealer makes by buying something at the low bid price and selling it high at the ask price

bond ratings

predictions by rating agencies as to the likelihood a bond issuer will default

bond trustee

a fiduciary hired by the bond issuer responsible for monitoring the bond indenture and ensuring the bond issuer fulfills its terms

callable/redeemable bond

a bond with a provision that gives the issuer the right to prepay the debt; since issuers will only exercise the call provision when interest rates fall, it imposes reinvestment risk on the bondholders

• U.S. Treasurys do not have call provisons

• munis and corporates might

capital gains yield

the annual percentage change in a bond’s price

• portion of a bondholder’s total return due to a change in the bond’s value

convexity

the curvature of a bond’s price response due to changes in yields

corporates

bonds issued by corporations that often have 20 year maturites but may extend to 100 years; corporate bonds have default risk because corps must generate cash for the contractually obligated payments through the unforced sales of goods and services to their customers

coupon payment

the interest-only payment the bondholders receive regularly

• the coupon rate * face value = total interest paid annually

• if bond is european style, coupon payments are annual 

• if american bonds are semiannual 

coupon rate

the percentage of the face value paid out annually as interest only

credit risk/default risk

the uncertainty about a bond issuer’s ability to make all its required paymentsc

current yield

the annual coupons divided by a bond’s price

• portion of a bondholder’s total return due to the receipt of regualr cash flows (coupons)

dealer

a market intermediaries that always stand ready to buy from sellers at the bid (low) price and sell to the buyers at the ask (high) price, thus taking the bid-ask spread as the per-unit profit

dealer market

a market where buyers and sellers for a good or service transact through an intermediary called a dealer

• this market structure implies that the dealer must hold inventory and that there is a risk that the price of the inventory may change while waiting to be sold

  • dealer markets known as over the counter (OTC)

debenture

a bond without collateral 

• all U.S. Treasurys are these

deep market

a highly active and liquid market with many buyers and sellersde

default

failure on the part of the bond issuer to fulfill the terms of the indenture, often by failing to make a coupon payment or pay the face value

discount bond

a bond whose price is less than its face value because its coupon rate is less than the yields on similar bonds; discount bond’s price will on average rise as the time to maturity shortens

duration

the average time it takes for the bondholder to receive the value of the bond

• the value-weighted average of the times when the bondholder receives bond payments

duration risk/interest rate risk/price risk

the risk that a bond’s price will change in unexpected ways due to unanticipated changes in interest rates

• longer a bond’s duration, the more sensitive the bond’s price to interest rate surprises

• all else equal, bonds with longer times to maturity have more duration rate risk than bonds with shorter times to maturity

• all else equal, bonds will smaller coupon payments have more duration risk than bonds with large coupons

european style

a bond that makes a single coupon payment each year

• amount equals the coupon rate times the face value 

face value/par value

the principal amount of a bond repaid at the end of the term

• typically $1000 but could be anything

• the known maturity payout amount of a financial security that is known by the buyer when the instrument is issed

fixed-income securities

another name for bonds

floaters

bonds that do not have constant coupon payments; instead, the payments vary with an inflation or interest rate index

holding period yield (HPY)

a bondholder’s realized rate of return having owned the bond for some time interval

• typically we calculate it given some final sales date that occurs before the maturity date

  • the holding period yield and the yield to maturity almost always differ

indenture

the written agreement between the bond issuer and the bondholders detailing all the terms of the debt issue

inflation risk

the chance that unanticipated inflation will erode the purchasing power of the payments the bondholder receives

interest rate risk premium

the additional compensation bondholders require for the increased price risk of bonds with longer times to maturity

inverted yield curve

the situation where long-term Treasurys have lower yields than short-term bonds

• inverted yield curves are uncommon and result from expectations that inflation or productivity will be much lower in the future

investment grade bonds

bonds rated BBB or above

liquidity

the ability to buy or sell an asset quickly at its full market value

• there’s an inverse relationship between liquidity and bid-ask spreads

• u.s. treasury bonds are highly liquid, trading in very deep OTC markets with small bid-ask spreads

• municipals are illiquid with large bid-ask spreads, while corporates fall in between Treasurys and munis

long-bonds

treasury bonds with 20 and 30 years to maturity

market maker

they act as an intermediary trading for their own benefit, but in doing so, match up buyers and sellers and improve market liquidity

• dealers are a type of market maker

maturity date

the date specified in the indenture on which the issuer pays the principal amount of a bond, thus paying off the loan

municipals/munis

bonds issued by state and local governments

• have default risk bc the issuers have a limited ability to tax

• maturity dates range from 20 to 40 years

• coupon payments are tax-exempt at the federal level

off-the-run

all the bonds of a type that were previously issued but are not the most recent

• i.e: if a 30 year bond was just issued, all other 30 year bonds previously issued are off-the-run bonds

on-the-run

the mostly recently issued debt for a given maturity date

• i.e: the most recently issued 30 year treasury bond is an on-the-run bond

over-the-counter (OTC) market

a dealer market

par bond

a bond whose price equals its face value because its coupon rate is the same at the yields on similar bonds

premium bond

a bond whose price is greater than its face value because its coupon rate is greater than the yields on similar bonds

• a premium bond’s price will on average fall as the time to maturity shortens

priority claim

the ranking of creditors’ claims should the borrower enter bankruptcy

• shareholders have the lowest priority claim (hence the name residual claimant)

protective covenants

a part of the indenture either prohibiting specific actions by the issuer, or requiring others during the loan term to protect the lenders

registered bonds

bonds where the issuer keeps track of who receives the bond’s cash flows

reinvestment risk

the risk that a bondholder will reinvest a bond’s cash flows at a lower rate of return when interest rates fall

• all else equal, bonds with shorter times to maturity have more of it than bonds with longer times to maturity 

senior debt

creditors with high priority claims on the cash flows of a borrower

• often have the right to seize collateral if a default occurs

sinking fund

a feature of some bonds designed to reduce the probability of default as maturity by using funds to remove bonds from the market over time

sovereign bonds

debts issued by national governments

subordinated debt/junior debt

creditors with low priority claims on the cash flows of a borrower

term structure of interest rates

the relationship between yield-to-maturity and time-to-maturity, all else equal

• in general: as the time to maturity increases, so do yields-to-maturity, though historically, there have been important exceptions to this pattern

thin market

an illiquid market with relatively few buyers and sellers, resulting in low volume and high bid-ask spreads

time-to-maturity

the number of years until the issuer pays the face value of the bond

Treasury bills

short-term U.S. Treasury debt with maturities of 1 year or less

• these are zero-coupon bonds

Treasury notes

intermediate-term U.S. treasury debt with maturities of 2 to 10 years

• bonds that pay regular coupon payments

treasury bonds

long-term u.s. treasury debt with 30 years to maturity, also called bellweather bonds

• these bonds pay regular coupon payments

yield curve

a graph of u.s. treasury times to maturity and their corresponding yields

• yield curves generally slope upward

yield-to-maturity (YTM)/yield/cost of debt

the interest rate the bondholders will earn if they hold the bond until maturity

• yields are annual percentage rates (APRs) and change with market conditions

• use trial and error to solve for bond yields

• yield-to-maturity may have 2 components: current yield and capital gains yield

zero-coupon bond

a bond that does not make regular interest-only payments

• treasury bills and pure discount loans and zero-coupon bonds